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LEASING is an integral part of the precious metals market, writes Miguel Perez-Santalla at BullionVault.

Why is it necessary? For a diverse number of reasons, the first is the need for industry to borrow instead of buying outright the metal. This enables them to avoid owning the metal at a fixed price if they have not yet contracted to sell their product.

Other companies want to borrow rather than buying gold or silver, to keep their cash consumption down. Leasing gives their business greater flexibility in money management. Still others choose to borrow to free up cash. Finally, there are those in a bridge lease, commonly used in the oil refining and pharmaceutical fields.

Follow up:

These companies already own all the precious metal that is needed, inside their pipeline. And as that platinum, palladium, gold or silver does its job, of cleaning out impurities from their end product (petroleum, drugs or other chemicals) it simply needs to be extracted from the waste byproduct and re-introduced to the process. But leasing gives the producer a little headroom while this goes on. They don't need to own any more metal than they use, because it always comes back to them.

On the flip side there are financial, trading and metal refining companies who own gold, silver or platinum-group metals, or have metal on account, which they need to put to work. The metal which they have on account is held as a debt to their customers, rather than being physically allocated to the client. That is what enables them to turn their liability into an asset by putting it to good use, leasing gold out to earn them money.

The reason you want to know about precious metals leasing is to understand what this function represents, how it actually affects the market place, and its relationship to the price. This little exposé will in no way be exhaustive about all the different uses and functions of leasing. But it will serve as a primer for understanding a market product and service that seems to be a mystery for many commentators.

First, the pricing: Just as with anything you might pay to borrow, longer-term leases typically cost more - per annum - than short-term arrangements. See this table of indicative lease rates for instance.

Click to enlarge

Another very important point you should remember is that the ability to borrow gold or silver through leasing is not a simple process. In fact, most businesses involved have very stringent credit practices, and depending on the entity may entail quite lengthy processes and documentation at the front end before you can effectively become a user of this type of service. So moving forward, let's assume for practical purposes that all parties to a transaction have met the highest credit standards.

We must also remember that the movement of valuables and precious metals is time consuming and expensive. Because of this, the marketplace created the ability to swap metals from one location - or from one period of time - with someone else that has it in another. Now, this is not something that is done for free. There is a charge which is determined by supply and demand for the specific location. Of course this is the kind of thing that can only be done if the two parties share the same interest. It is incumbent on anyone in the precious metals industry to establish trade relationships in the major markets that enable them to participate.

What does a swap have to do with leasing? If you are asking then I still have your interest! The reason is that location swap transactions happen to be a major part of the ability of institutions to lease or lend their metal to another party is because it increases the size of the available market.

So how does someone end up in the gold leasing business? For most, it's because they have active business in the metal from the get go. In this case we can say a bank involved in precious metals, a trading company or precious metals refining business would have natural flow of business that would enable them to be in a position where they could offer leasing. In the first example we will call this primary entity Company A.

Company A has customers who hold metals on deposit. They're not charged anything for this service, on the condition that Company A can use it in the meantime. Those clients have given their asset and accepted Company A's good credit that they will deliver it back when needed. It is in reality no different that when you leave your money with a banking institution. The only difference is that the gold does not multiply through the banking system as money does. Because the sum total of physical metal does not change.

Let us make believe you are Company A and you have 10,000 ounces of gold deposited by your customers. Of those, you are able to lend out 8,000 ounces easily. But now you have an excess. So you calculate the earnings if you sell the gold outright in the market, and deposit or lend the cash to another borrower. To make sure you can give your clients the metal they're owed, you also need to hedge yourself by buying gold back at a later date against a forward or gold futures contract (often referred to lately as paper gold) to avoid price risk.

In the current market environment, this could be profitable. Because the near term price is higher than the forward or future price (the market is in what's called backwardation). You would pocket the premium for selling immediate gold, and buy the future delivery cheaper. Over that time period, you also lend the cash raised from the sale as well. It is a bonanza!

But it does not happen like this most of the time, and besides - Company A has multiple transactions and commitments in gold. So the picture I projected, though nice, is not always that simple.

Let's make believe the market is in full contango. This is the typical state of the gold and other precious metals markets. It means that the future or forward price is higher than the near term. So if you were Company A, then the spread would cost you money to hedge your position, and it would cost you more than you would earn, too.

What to do? You contact other people in the market place - outside your own circle of gold borrowing clients - and it happens that you can lend it to another party that has need for the gold in New York. He will pay you a premium, because he doesn't have any there and needs to deliver to a manufacturer. But instead of just outright borrowing, he wants to give you gold in London - the most liquid physical gold market in the world - at the end of the term, which may be for 3 months. This sounds good. You can earn the premium for New York because he needs it there, and you have no price exposure. That is the simplest route from the point of view for Company A.

Now let's look at the different reasons to lease gold. Let's take a jeweler. A jeweler needs to produce 10,000 gold rings for Macy's (or whoever). But he does not want to buy the gold and take the price risk. Because the jewelry outlet does not want to price it until the goods are ready, especially if they expect the gold price to be lower.

The jeweler then borrows the gold from Company A and pays a percentage just like any loan for the term they are borrowing the metal based on the price of the day they borrow the gold. At the end of this lease they would then buy the gold from Company A at the same time they sell the metal to Macy's.

Another possibility is the gold miner who needs to pay his employees and expenses. This company expects to have one thousand gold ounces from their recent production. The metal however will take 30 days to be available from the refiner, ready to sell in the market. So the miner leases the gold for one month from Company A, selling the gold for cash and paying its bills. They then deliver the refined gold to Company A at the end of that term.

There is also a manufacturer that uses precious metals as part of a catalyst. They already own what they need. But because the process to reclaim the metal from the catalyst is time consuming, and because they need a fresh catalyst immediately when they remove the old one, they need to lease some metal for that time period.

In leasing there are many other models and it can be used for other purposes, much like in the stock market. To sell short is one such use. It means to sell what you don't have because you expect you will buy it back cheaper at a later date. But in the precious metals market, however, you don't need to do that with physical metal if you have access to the futures market. Speculation using physical bullion - borrowed and then sold directly into the marketplace in the hope of buying back later at lower prices - just doesn't make any commercial sense when the futures (aka paper gold) market enables you to do it much faster, without the need for long and involved credit checks like we saw earlier.

There you have the basics of precious metals and gold leasing. Just like anything in the world, what should always be simple is complicated by some to create some advantage in most cases. If you understand the basics you can work make your way through any other related concepts.

So what kind of effect can the leasing market have on pricing? It really all depends on liquidity. Unlike currency - where the Fed can come in and inject more money into the system - this is not possible in a truly finite market like precious metals. But thanks to the available supply above-ground, some precious metals markets are more susceptible to a liquidity crunch than others. For the next example I will use a true to life market occurrence.

In November 2006, I remember like it was yesterday, I walked into my office on a Monday morning and platinum was up $200. It had jumped from the $1200 level to over $1400 dollars. This was more than a 16% move from one day to the next. The chatter and market reports back then were that a bank trader was short a large amount of platinum, and was being forced to deliver on his short position on that Monday by other players who had got wind of his problems, and took the opportunity to profit from it.

Because his short position was so large, and because the platinum market is so small, his covering drove the price up. This happened because typically in the platinum market, much of the metal is out on leases. It would take some time to get all the metal back to make the delivery.

In this circumstance there were industrial users who knew their leases were coming due at that specific time period too. Because of this large short covering in platinum, the price shot up not just on the commodity but on the platinum lease rate as well. That day in fact, the industrial customer that was expecting to pay 3% to 4% for a 1-year lease was being offered at between 100% to 120% per annum! The consumer had no choice but either to return the platinum they'd leased, buy it outright, or accept the new rate.

In this instance, the best way to manage the situation was to lease day by day. As it worked out, the market calmed down and three days later the lease rates were essentially back to normal. But if the industrial consumer had decided to buy it at that elevated price level, he would have suffered a major - and unnecessary - rise to his costs. By the end of that week, the platinum price had also retreated.

Take note: the platinum market is far less liquid than gold or silver, meaning that there is less supply and demand. So its wild gyrations would not be probable in gold or silver markets. However, there is still a possibility of a similar circumstance. It's just less likely that moves of that size would occur, because they are very much larger markets. And in the end it is not the lease rates that affect the market price, but immediate physical demand and price which affect the lease rates.

Leasing is a tool just like any other. It has its proper function, just like a knife for cooking, a rifle for hunting, or a gun for self-defense. That does not mean they are not misused, and often intentionally. But this does not negate their purpose and need in the market.

Some decry that the ability to lease metals enables the multiplication of the metal. However this is not true. It may multiply the commitments, but physical leasing is unlike money - which is multiplied by the ability of financial institutions to hold only a minimal part of the reserve as cash on hand.

With the precious metals market, in contrast, the commitments are for physical metal and delivery is always necessary at some point. Hence it is not a stroke of a pen, but the blood, sweat and tears of miners, refiners and logistics companies that produces or brings gold back into the market.

Yes, leasing might invite poor judgment on the part of a lender, or borrower. But the contrast that to the lack of metals industry failure with the repeated and increasingly common failure of financial and banking entities. Having to deliver rare, physical metals keeps errant trading to a minimum in a way which Fed-guaranteed bail outs of banking and financial brokerages does not.

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events - and must be verified elsewhere - should you choose to act on it.

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